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European credit: Don’t ignore the fundamentals

May 2016

The European Central Bank hopes its new corporate bond purchase programme will benefit the real economy in the euro area. But as Joubeen Hurren explains in a Q&A on the initiative, investors should watch out for the distortive effects of a price-insensitive buyer entering the market.

On March 10, the European Central Bank (ECB) announced the addition of the corporate sector purchase programme (CSPP) to its quantitative easing toolbox. The CSPP could result in the ECB purchasing between €5 billion and €10 billion every month of bonds issued by investment grade-rated non-bank companies domiciled in the euro zone.

The scheme, which will begin in June, will see the central banks of Belgium, Germany, Spain, France, Italy and Finland act on behalf of the ECB to purchase corporate bonds in both the primary and secondary markets. To be eligible, the bonds must have a minimum rating of BBB-, and remaining maturities ranging from 6 months to 30 years.

In explaining the rationale for the programme, the ECB stated: “The CSPP will further strengthen the pass-through of the Eurosystem’s asset purchases to the financing conditions of the real economy. As a result, and in conjunction with the other non-standard measures in place, the CSPP will provide further monetary policy accommodation and contribute to a return of inflation rates to levels below, but close to, 2% in the medium term”.

Even before its official launch, the programme has led to a significant tightening in spreads, with the yield-to-worst level on Bloomberg’s European Investment Grade Corporate Bond Index contracting from 1.0753 per cent on March 10 to 0.8151 per cent on May 16.

Credit fund manager Joubeen Hurren answers questions on whether there is room for further spread tightening and how effective the programme will be.

Despite questions over the effectiveness of the ECB’s quantitative easing programme, it is now expanding its purchases to include corporate bonds. Is that a good thing or could it have unintended consequences?

The ECB is ultimately going to own between 5 and 10 per cent of the European corporate bond market in the next two years – clearly that will have a distorting effect. We have a price insensitive buyer coming in and absorbing a significant amount of new supply as well as being active in the secondary market. In fact, we’ve already seen a big differentiation between bonds that are eligible under the CSPP and those that aren’t, with about a 30 per cent tightening in eligible bonds versus 18 per cent in ineligible bonds.

That’s a significant tightening in spreads before the programme has even launched. How much further can corporate bonds rally?

Short-term, it has provided positive technical support for the market and there is a lot already priced into valuations. Longer term, however, it could lead to a misallocation of capital if some investors focus too much on the technical benefit and not enough on the fundamental strength of the issuers. I wonder if down the line we’ll be talking about the negative consequences of this programme; not necessarily the first order effects, more the second order effects.

If you look at where the United States is in terms of the credit cycle, we’re starting to see defaults coming through in certain parts of the high yield market, particularly in the energy sector. The Federal Reserve started quantitative easing back in 2009 and that saw money flow to all parts of the credit market. There is a lot of discussion now about whether energy companies should have been funded at the low rates they were or whether QE there led to an inefficient allocation of capital; propping up companies that shouldn’t have been supported.

When we look at the CSPP, the ECB’s focus is on investment grade, but there will also be a crowding out effect into other parts of the market – we have already seen European high yield tighten by 100 basis points.

So, there is reason for investors to be concerned about European corporates taking on more debt than is good for them?

Despite the economic backdrop, the truth is that Europe has been a source of stability within the global credit market in terms of fundamentals. US investment grade (IG) net leverage – measured by net debt-to-EBITDA – has increased from 0.9 times in September 2007, just prior to the financial crisis, to around 1.5 times now, according to Deutsche Bank. European investment grade leverage, by contrast, hasn’t moved over this period, and remains around 1.6 times.

The concern is that European credit follows the USA’s example, with leverage starting to creep up in the next couple of years, fuelled by cheap financing. Energy might not be the trouble spot in Europe – it could be a different sector that is allowed to fund itself at levels that aren’t representative of its underlying credit quality.

How difficult is it to differentiate between credits in an environment where the market is heading in the same direction?

Although we know that the ECB is going to be a big driver from a technical standpoint, in some ways it makes the job of stock picking even more important; certainly over the medium to long-term. At some point this ride is going to stop: investors should be careful not to chase investments in companies based purely on technicals.

We’re certainly not changing our process. We rank credits on an FTV (Fundamentals, Technicals and Valuations) score, and we would never advocate forgetting the F and V on the basis that technicals will be a critical factor for the next 12-18 months. Ultimately you have to be comfortable that the credit you are adding to a portfolio is on a positive trajectory in terms of its fundamentals.

In justifying the CSPP, the ECB believes it will “strengthen the pass-through of the Eurosystem’s asset purchase to the financing conditions of the real economy”. Is it naïve to think that new borrowing will be used for productive purposes?

This move is well-intentioned but it is difficult to predict with any certainty what the money will be used for. In the US we’ve seen a lot of corporates issue debt for M&A and to fund share-buybacks because there have not been enough organic growth opportunities. Growth is more anemic within Europe than the US, so it is difficult to see companies using the debt for the productive, growth-generating purposes the ECB would like to see.

One other question mark over this programme is whether money will flow to the economies that need it most, in peripheral Europe for example.

That’s a fair question. We know that the purchases will be conducted by six central banks in the euro area – what we don’t know yet is how the investment will be split across the region from a geographical perspective.

The most likely impact of this programme is that it will provide a cap on spreads. When spreads on European investment grade credit were around 120 basis points, the market seemed to be pricing in a global recession. Now that the ECB is entering the fray, we are much less likely to reach those levels over the next 12 months. Spreads are likely to stay capped within a range relatively close to where they are now.

If, as you predict, much of the rally in European investment grade is already priced in, how do you position portfolios in such an environment?

While you have to be very selective in terms of names, European high yield (HY) could provide opportunities. You can get paid a 5 per cent yield for 3.5 years duration, so even if spreads were to widen over 100 basis points from where we are now that is still a money-making trade. At the other end of the spectrum, we are looking at trades in the options market that offer downside protection. While QE does suppress volatility and spreads should stay within a fairly tight range for the most part, you can never ignore the risk that volatility spikes for some exogenous macro reason; such as a major slowdown in China.

Although it seems that many factors are pointing in the right direction for credit, the one thing that isn’t is the fundamentals. At the moment we are in a market where fundamentals are being largely ignored. But it is unlikely to stay that way for too long so we certainly don’t want to buy credits that are of lower quality just to participate if the market grinds higher.

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 16th May 2016. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

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In Summary

The ECB’s new corporate bond purchase programme, to be launched in June, is already having a positive impact on spreads

We are concerned that it could lead to a misallocation of capital if some investors focus too much on the technical benefit rather than the fundamental strength of the issuers

European credit could also follow the USA’s lead, with leverage creeping up in the next couple of years, fuelled by cheap financing

Much of the rally in European IG is already priced in but European HY will provide opportunities as long as investors are very selective

Joubeen Hurren

Senior Portfolio Manager AIMS Fixed Income

Main responsibilities

Joubeen is a co-manager of the AIMS Fixed Income portfolio. Joubeen is a permanent member of the Strategic Investment Group (‘SIG’), where all investment ideas that are proposed for inclusion in the AIMS portfolios are rigorously debated.

Experience and qualifications

Joubeen joined Aviva Investors’ graduate scheme in 2011 gaining experience in a number of roles in both fixed income and equity. Prior to joining, he worked at Bank of New York Mellon in client relationship management within the business development team. He began his career in marketing at French cosmetics group L'Oréal.
Joubeen holds a degree in Business Administration from the University of Bath and is a CFA® charterholder.